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As I write this, word has not yet come down from the


mountaintop, although it is expected imminently. The Federal Reserve is widely expected to leave interest rates unchanged today. Still, many believe the central bank will switch its "balance of risk" statement to neutral as a prelude to a tightening of monetary policy sometime this year, perhaps as early as its May 7 meeting.

So while it may be jumping the gun just at bit, now seems as good a time as any to think about what kind of stocks fare best in a tightening environment.

Intuitively, underweighting cyclical stocks and overweighting noncyclicals, such as consumer staples, makes sense when the Fed begins tightening. The assumption being that such action by the central bank will slow the economy, and thus hurt the most economically sensitive names.

Lo and behold, recent history suggests such a strategy is prudent.

In the 12 months following the first Fed tightening in August 1961, June 1983 and February 1994, cyclical stocks underperformed, while noncyclicals outperformed, Lehman Brothers chief investment strategist Jeffery Applegate confirmed in a report released yesterday.

Most industry groups in the consumer discretionary, financial, industrial and materials sectors (as defined by the

S&P 500

) posted negative returns for the first year following the beginning of all three tightening cycles, Applegate's study found. With the exception of integrated oil and gas, energy also underperformed in all three time frames. Conversely, industry groups within consumer staples and health care were among the best relative performers.

For illustrative purposes, the following table shows the average relative returns for the major sectors after the beginning of the 1994 tightening cycle. The table is limited to the 1994 cycle because the S&P industry definitions have changed so much since 1961 and 1983. (Similarly, there are six current S&P industry groups that were created after 1994.)

Applegate limited the study to the 1961, 1983 and 1994 tightening cycles because the central bank "succeeded in slowing but not arresting GDP growth

and that's what we believe the Fed will attempt to engineer later this year and next."

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Snarky aside No. 1: Other than a so-called soft landing, what else would the Fed "attempt" to engineer?

As mentioned above it's probably a bit early to start positioning portfolios for a tightening cycle. Notably, Applegate is currently underweight health care (4% vs. 11% in the S&P 500) and consumer staples (0% vs. 9%), while overweight consumer discretionary (36% vs. 13%), industrials (17% vs. 11%) and materials (5% vs. 3%).

The current portfolio strategy is "precisely the reverse of" what has historically worked "because we think it is too early to reposition the portfolio for the next round of central bank tightening," he wrote. "But as the Fed starts moving to that regime later this year, we'll look to change our strategy to a more defensive one."

Furthermore, Applegate believes current market expectations of at least 150 basis points of Fed tightening between now and year-end is "too much, too soon."

"To get there would take much stronger final demand and inflation than we think likely over the next few months," he continued. "With inflation falling and productivity growth rising over the next few quarters, we think the Fed is unlikely to get agitated about an inflation problem in the pipeline."

The Economic Cycle Research Institute's future inflation gauge (FIG) only bottomed out in January, the strategist noted. Fed tightening has followed cyclical troughs in the FIG by an average of eight months, he reported, suggesting the first rate hike won't occur until September.

"Accordingly, we would argue that now is not the time to rework one's portfolio for Fed tightening," Applegate concluded. But "as the adage goes, 'forewarned is forearmed.' "

True Confessions

It's been a long time since I've reported on Applegate's work because of his unrelenting bullishness about the market overall and technology in particular throughout much of the past two years.

At 80% stocks, 10% bonds and 10% cash, Applegate's recommended allocation remains at the high end of the so-called major strategists, but not of the most aggressive. (First Union's Rod Smyth recommends 85% stocks and 15% bonds for moderate-risk portfolios and 100% stocks for high-risk accounts.)

Similarly, Applegate's year-end target of 1350 for the S&P 500 and expected operating earnings of $53 a share for 2002 and $58 for 2003 are relatively high vs. consensus, but not wildly so.

Finally, Applegate currently recommends an underweight allocation in information technology (10% vs. 16% in the S&P 500) and telecommunication (1% vs. 5%), which is curious for a strategist who is (still?) associated with tech bullishness.

Snarky aside No. 2: Contrarians, take note of the above.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.